Calculating Tax-Equivalent Yield

Transcript

When we talk about fixed income, it’s important to put the stated yield in the right context. Especially in taxable accounts, pre-tax yields can be misleading, because what ultimately matters to the client is the income they keep after taxes.
This is particularly important when comparing municipal bonds to taxable bonds. Municipal yields are often lower on the surface because the interest is generally exempt from federal income tax, and in some cases may also be exempt from state income tax for in-state residents.
That’s why tax-equivalent yield exists. It’s a simple way to translate a tax-exempt yield into the taxable yield a client would need to earn to reach the same after-tax outcome, based on their tax rates.
Tax-equivalent yield, or TEY, is the taxable yield required to equal the after-tax income of a tax-exempt bond.
At the most basic level, using federal taxes only, the formula is straightforward: tax-equivalent yield equals the tax-exempt yield divided by one minus the client’s marginal federal tax rate.
In other words, TEY equals tax-exempt yield divided by one minus the federal tax rate.
If you want to include state taxes, the same logic applies, but there are a few additional considerations. The relevant combined marginal rate depends on the client’s situation, and that can vary across households and across states.
Let’s apply this across the three common building blocks advisors compare.
Municipal bonds generally pay interest that is exempt from federal income tax. State tax treatment depends on where the investor lives and where the bond is issued.
U.S. Treasuries are taxable at the federal level, but the interest is typically exempt from state and local income taxes. That state exemption can matter, particularly in higher-tax states.
Corporate bonds, on the other hand, are generally taxable at both the federal and state levels, which means the stated yield can overstate what the client actually keeps after taxes.
The takeaway is straightforward: for higher-bracket investors, a lower nominal municipal yield can still translate into higher after-tax income versus taxable bonds, depending on relative value and the client’s tax situation.
Over time, the relative attractiveness of munis versus Treasuries and corporates shifts as municipal supply and demand change, as Treasury volatility changes, and as credit spreads widen or tighten. That’s exactly why advisors should run the tax-equivalent yield math rather than rely on rules of thumb.
A simple decision rule is that in-state munis can provide an incremental benefit in higher-tax states, because the interest may be exempt from state income tax for residents, subject to that state’s rules.
Out-of-state munis may still be federally tax-exempt, but they may be subject to the investor’s home-state income tax. When that happens, the effective after-tax yield is lower than it first appears.
In practice, this is a state-by-state rule set. And if the client lives in a no-income-tax state, the in-state advantage is usually minimal. In that case, relative value and portfolio fit often drive the decision more than state tax considerations.
Here are two simple examples using basic math.
First is a federal-only example using the top federal bracket inclusive of the Net Investment Income Tax, or 40.8 percent.
Assume a municipal bond yields 4.00 percent. Tax-equivalent yield is the tax-exempt yield divided by one minus the tax rate. One minus 40.8 percent is 59.2 percent, or 0.592.
So the math is 4.00 percent divided by 0.592, which is roughly 6.76 percent.
Put plainly: for a client facing a 40.8 percent federal marginal rate, a taxable bond would need to yield about 6.76 percent to match a 4.00 percent tax-exempt yield, using federal taxes only.
Second is the state-tax example, at a high level. If a client lives in a higher-tax state and buys an in-state municipal bond, the interest may be exempt from both federal and state income tax, subject to the state’s rules. If they buy an out-of-state municipal bond, the interest may still be exempt from federal tax, but the client may owe state income tax, which reduces the effective after-tax yield.
So the advisor decision rule is simple: when state taxes are meaningful, in-state munis can improve the after-tax result, but you still need to compare relative value, credit quality, call features, and diversification. And if the client lives in a no-income-tax state, the decision is usually driven more by value and portfolio fit than by state tax considerations.
In summary, tax-equivalent yield is the starting point. After you run the TEY math, you still layer in portfolio construction, credit quality, liquidity, and diversification to make sure the solution fits the client’s objectives.